Don't stretch to buy a house with interest-only loans

Hundred dollar bills in shape of house

Some people will do almost anything to buy a house. If they can't qualify for a mortgage that requires them to pay both interest and principal, they get one that allows them to pay only the interest...for the first five years.

After that, things can get expensive.

That's why no one should get one without understanding all the risks and thinking twice.

Since they were first introduced in late 2001, interest-only loans have been the fastest-growing type of mortgage in America, according to Bob Visini, vice president of marketing for LoanPerformance, a San Francisco-based mortgage research firm.

In 2001, they were but a blip on the radar screen -- 1.6% of new mortgages. By last year they had grown to nearly one third of all new mortgages.

"In places where housing prices are climbing through the roof," Visini says, "in the San Francisco Bay area, Los Angeles, Seattle, Boston, and in New York, for example, they represent 50% of all new mortgages -- in some cases more than 50%."

As the name suggests, with an interest-only mortgage, all you pay is the interest.

This means a smaller mortgage payment every month. It also means that you are not doing anything to reduce the principal. If you borrow $250,000 and make the interest payments every month for five years, you will still owe the lender exactly $250,000.

Two factors are driving the trend: 

With an interest-only loan, you can reduce your monthly payment and qualify for 25% to 30% more house. That's because the limit on the amount you can borrow is based on how much you can afford to pay every month, not on how much of it goes toward reducing the principal.

That does not, however, stop you from accumulating equity in your home. After all, you can build equity two ways: you can reduce the principal owed, or the home's value can rise. If you have not reduced the principal, however, your equity is limited only to increased property values.

People who take out interest-only loans have different ways of handling them.

Some make extra payments -- regularly or occasionally -- to reduce the principal.

Others count on their home's value rising so that when they sell, they will reap some profit from the deal even though they haven't reduced the amount of the loan by a single penny.

For homeowners who keep such a mortgage until the interest-only time runs out, the big risk is what could happen to their monthly payment.

"Interest-only loans change after five years, in most cases turning into an ARM (adjustable rate mortgage) amortized over the next 25 years. So you are paying off the principal in 25 years instead of 30, and you are doing it at whatever the interest rate is at the time," Visini says. "It can be sizable payment shock at that point."

At least that's what people assume. Since interest-only loans are so new, no one knows what will happen when they come due because the first are turning five years old this year.

Interest-only mortgages are tempting, even though they cost about a quarter-point more than a conventional mortgage. Since most interest-only loans are for expensive homes, they often require jumbo loans that also carry a higher rate than a normal loan.

To keep this simple, however, we will look at two loans for the same amount at the same interest rate.

Let's say you borrowed $250,000 at 6%. For a traditional 30-year fixed-rate loan your monthly payments for interest and principal not counting taxes, insurance or other assessments -- would be roughly $1,500.

If you took out an interest-only loan to reduce your monthly cash outflow, you'd save 20% and have a basic monthly payment of $1,200.

But what if you want to get as much house as you can? If you could make a $1,500-a-month payment, you could get an interest-only loan on a home costing 20% more, or $300,000.

Let's say you decide to go for the bigger house and take out a 6%, interest-only loan for $300,000. At the end of five years you will have paid $90,000 in interest, and even though the interest is tax deductible you still would owe $300,000 in principal.

At that point you could either refinance or convert your loan to a 25-year ARM. If you could convert it to a 6% ARM, your basic monthly payment, interest and principal would jump 29% to $1,933.

If, however, you could refinance at 6% for 30 years, your basic monthly payment would be $1,799. That's $134 or 7% less than it would be over 25 years but still $298 or 20% more per month than it had been as an interest-only loan.

Of course, your payments will go up even more if interest rates are higher then than they are now and by historical standards, they are very affordable right now.

Given that, you should be very careful about using an interest-only mortgage to qualify for a house that stretches your finances to the breaking point.

What happens in five years when your mortgage payments almost certainly go up?

You may not want to know.

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